Extract from:
Miller, A. (1998) Strategic Management, McGraw Hill, 3rd edition
Chapter 7 Corporate-Level Strategy, pages 255 - 275
EVALUATING THE BENEFITS OF DIVERSIFICATION
Theorists commonly cite six reasons as benefits of diversification. We evaluate these reasons in light of our standard for good
corporate management developed in Chapter 1 and in the opening section of this chapter: creating value for stockholders that they
cannot create for themselves. We begin with the most powerful reasons for diversifying and then move on to those that are less
defensible but still commonly cited as motives for diversification. Exhibit 7.3 arranges the six according to their power to create
value.
Capitalizing on Core Competencies
Core competencies are the most significant value-creating skills within a corporation. These skills can often be
extended to products or markets beyond those in which they were originally developed. 51 Such extensions represent excellent
opportunities for diversification. For example, when it considered diversification targets, Philip Morris believed that the core
competence it had developed in marketing cigarettes could apply to other, similar markets. Based on this idea, the company
purchased Miller' Brewing and then used the Philip Morris marketing skills to move the Miller brand from seventh place to second
in its market.
Any core competence that meets the following three requirements provides a viable basis for the corporation to strengthen a new
business unit. 52
The core competence must translate into a meaningful competitive advantage. In other words, the
competence must help the business establish some strength relative to its competitors. Every core process and each of the major
activities in the value chain is a viable basis for building on a core competence. For instance, Black & Decker enjoys a core
competence in developing products with small electric motors and rechargeable batteries, and has successfully diversified this
competence from small power tools for woodworking into higher-margin items such as electric kitchen appliances, miniaturized
vacuum cleaners, and rechargeable flashlights.
The new business must have enough similarity to existing businesses to benefit from the corporation's core
competencies. This is one reason related diversification is more profitable than unrelated diversification on average. However, this
does not necessarily mean that the products themselves must be similar. Rather, at least one element of their value chains must
require similar skills in creating competitive advantage in order for the corporation to capitalize on its core competencies. An
example is Coca-Cola's move into leisure clothing. At first glance, one might think that soft drinks and sweatshirts have little in
common, but in an important strategic sense they are, in fact, closely related; the marketing of both can be based on selling a
trademark and an image as much as on selling the product itself. In soft drinks, its core business, Coca-Cola emphasizes marketing
as a key component of its value chain by building demand through strong customer awareness. Coke used this same expertise in
marketing an image to successfully introduce a line of clothing bearing various Coca-Cola trademarks. In its first full year of
business, Coca-Cola Clothes generated $100 million in wholesale revenue - impressive growth in any industry and by far the best
in the clothing industry.53
The bundle of competencies should be difficult for competition to imitate. As explained in Chapter 4, if the
transferred skills are widely available or easily replicated, they are unlikely to provide the basis of a sustainable competitive
advantage. 54 An individual core competence need not be unique; rather, it is the collection of competencies that should be
unique, or at least difficult to replicate. For example, Canon, the Japanese diversified manufacturer, has demonstrated an
unmatched ability to enter and dominate markets stretching from photocopiers and cameras to laser printers. Its dominance in these
varied markets rests on mastery of crucial technologies for successful engineering and design of all these products. Canon is a
world leader in its core competencies of optics, imaging, and microprocessor controls. Other companies are good at one or another
of these technologies, but Canon is arguably the best overall. This provides the company with a basis for diversification that
competitors cannot easily match.
A corporation that builds on core competencies utilizes skills that combine to strengthen value chains and build greater
competitive advantages. This leads to synergies among business units, whereby they become more productive together than
independently. The collection of skills used in this situation is largely intangible, but, as we discuss in the next section,
corporations can also build synergies by sharing tangible resources.
Increasing Market Power
To understand the impact corporate diversification can have on a business unit's market power, compare the structural position of
an independent business unit against what it would enjoy as part of a larger corporation. For instance, consider the position of an
independent confectioner versus the same business as part of, say, Procter & Gamble on each of the five competitive forces
introduced in Chapter 3. Membership in the P&G family can provide the business unit with greater bargaining power vis-avis both
its suppliers and its customers, as the large corporation carries more clout. With the resources available from the "deep pockets" of
a firm like P&G, the individual business unit is also in a much stronger position relative not only to its rivals, but also to threats
from substitutes and new entrants. Any competing firm evaluating the strength of our hypothetical Candy maker is likely to view it
as a much more significant rival if it is part of the P&G corporate behemoth than if it is a single, stand-alone business. Association
with the larger corporation may also bring the individual business unit increased visibility and an improved image. If so, this could
have a favorable impact on any or all of the five forces affecting the business unit's structural position and ultimately on its
competitive advantage.
Corporations may also increase market power by using mergers and acquisitions to consolidate their industries. For
instance, Maytag, a leading U.S. manufacturer of domestic appliances, sought to improve its power with suppliers and customers
by acquiring a number of business units that both extended and supplemented its core product line. Many of Maytag's acquisitions
entailed horizontal diversification in that they moved the firm further into parts of the value chain it had already had a position in;
for example, Maytag already manufactured domestic kitchen appliances, but acquisitions gave it a stronger position in
manufacturing commercial kitchen appliances. However, a firm can also use diversification to become more vertically integrated
and thereby increase its power over suppliers and/or customers by making them a "captive" part of the same corporation. Maytag
purchased firms that had once been outside suppliers of component parts such as heating elements for stoves and dishwashers.
Finally, membership in a larger corporate enterprise may provide a business with markets or distribution channels it could
not access on its own. A number of attempts to enter the U.S. soft drink market failed because the businesses could not overcome
the entry barriers created by that\industry's tightly controlled distribution channels. However, the soft drink business unit created
inside the Wal-Mart corporation found a ready-made distribution channel provided by the thousands of Wal-Mart retail outlets
scattered around the United States. In this way, that soft drink business enjoyed a much more f3vorable structural position and
greater market power as part of the WalMart Corporation than a similar business would have had as a stand-alone entity.
Government agencies that oversee industry competitiveness (such as the U.S. Federal Trade Commission) often place limits on
how far a corporation can diversify to gain power, and a move that is believed to place too much power in the hands of a single
corporation may be prohibited. For example, government regulators are carefully considering Microsoft's move into on-line
services. This diversification move would allow Microsoft to increase its market power by vertically integrating forward;
subscribers would be able to download Microsoft software without going through a traditional retailer. Regulators are concerned
that this might place too much power in Microsoft's hands, and they are considering stopping the move. However, within such
limits, diversification that improves the market power of the various business units constituting the corporation clearly meets our
criteria of creating value for stockholders in a way that they cannot replicate themselves.
Sharing Infrastructures
To capitalize on core competencies, firms must share intangible resources, such as skills, know-how, and talent, across
business units. Infrastructures, on the other hand, are tangible resources, such as production facilities, marketing programs,
purchasing procedures, and delivery routes. 55 These are the basic "nuts and bolts" of any business, and the ability to share these
resources can be an important benefit of diversification. Procter & Gamble, for example, uses a common delivery system for
various business units. P&G sells a wide range of products that are manufactured in facilities spread over an equally wide
geographic area. Yet many of these items share two characteristics: they are destined for the same retail outlets, and they are fairly
expensive to ship. Because of this, it is more efficient for P&G's various businesses to share delivery systems. Rather than send an
entire truckload of cookies to a single retail outlet, P&G mixes its truckloads to provide the product blend each customer desires.
Thus P &G can use one truck with a mix of items to do what otherwise might require a dozen trucks. In addition, because it is
inefficient to ship "pure" loads of very light but bulky items (such as potato chips) or very dense goods (such as liquid laundry
detergent), P&G saves on fuel bills and road taxes.
Note the two features that allow P&G to benefit from sharing infrastructures. First, the businesses have similar needs-they
use the same retail outlets. This is another benefit of related diversification; without similar needs, businesses have no opportunity
to share infrastructures. Second, delivery expenses represent a significant part of the value chain for these products, so they help
determine the competitiveness of P&G's products. In other words, to be useful, resource sharing must improve competitiveness.
Balancing financial Resources
Different businesses (even within the same corporation) generate dramatically different levels of cash. Some businesses
produce more cash than necessary to continue operating, while others need more than they can produce. Historically, managers in
diversified corporations emphasized efficiently balancing cash flows among a corporation's business units. By combining cash
producers and cash users in the same corporation, managers can meet the needs of both.
In such a corporation, the sibling businesses become a portfolio of investments, and managers balance cash flow across
the family of businesses rather than merely within each individual business. This approach, called portfolio management, first became popular in the 1970s, when a number of leading corporations and consulting firms developed several similar frameworks to
guide managers in allocating cash among diverse business units. 56 Some of the decisions involved in portfolio management are
presented in Application 7.3, which looks at General Electric's efforts to balance the cash flows of its various business ventures.
We shall briefly consider three popular variations of portfolio management and then look at the general benefits and limitations of
this approach. 57 The various versions of the portfolio approach are named according to the labels of their grids' axes.
The Growth - Share Matrix
According to the growth-share matrix, developed during the 1970s by the Boston Consulting Group (BCG), two relatively simple
factors predict whether an individual business will be a cash producer or a cash user: (1) the growth rate of the market within which
the business competes and (2) its share of that market. Businesses in fast-growing markets usually need more cash to scale up
production, open new facilities, advertise, develop new products, and so on. On the other hand, businesses in declining markets
may have already lived through their peak periods of product demand and are more likely to have sufficient assets to serve the
present dwindling demand. Businesses in this situation generally produce considerable cash but do not have a ready place to invest
it. Thus, businesses in growing markets may need more cash than they have, while businesses in mature or declining markets may
have more cash than they need. Additionally, businesses with large market shares more likely enjoy economies of scale and greater
experience curve benefits. Lower costs mean higher profits, and higher profits mean greater cash flows. In short, the BCG's
framework suggests that higher market shares are associated with greater cash flows. Exhibit 7.5 (BCG Growth Share matrix)
shows the combined effects of market growth and market share, and we can see how each of the four cells of the matrix indicates a
different strategy.
Cash cows usually produce far more cash than they can usefully employ in house. Corporations often "milk" such
businesses to finance other businesses on which the corporation's future may depend. Dogs hold small shares of slow-growing (or
even declining) markets and they are unlikely ever to become important sources of cash. In fact, they may be greater users of cash
for which there is little likely return. Experts often suggest that such businesses be "harvested" by not investing in them and instead
shifting cash flows to more promising businesses. Problem children have low market shares of rapidly growing markets. They
represent a potential opportunity; if their market shares can be increased, they might become cash cows. However, if they cannot
increase market shares before market growth slows, they will, in effect, become dogs. Developing a strategy for problem children
means either investing large sums in hope of gaining a viable market share or not investing and possibly missing a growth market.
Stars are often the hope of the future. They currently hold large market shares in rapidly growing markets, so their cash flows may
be minimal or even negative. Recommended strategy dictates that they be nurtured, maintaining their health and waiting for market
growth to slow so that net cash flows will increase. Theoretically, the cash-hungry stars will be transformed into cash-rich cows
that can be milked to nurture still another generation of businesses.
The Market Life Cycle-Competitive Strength Matrix
Critics of the growth-share matrix contend that it fails to consider the wide range of factors that affect cash flow beyond market
growth and market share. A somewhat more involved picture of the situation facing a business can be depicted by adding a
judgmental assessment of the overall competitive strength of the strategic business unit (SBU). A second refinement utilizes the
richer concept of the market life cycle as a replacement for market growth. Recall from Chapter 6 that growth rates vary predictably across stages of the market life cycle, but that the life cycle model depicts various strategic issues beyond simply growth.
The explicit consideration of the market life cycle found in this portfolio management framework provides a useful bridge between
strategy formulation at the business level and at the corporate level. Exhibit 7.6
Source: This type of matrix was originally developed by Arthur D. Little, a consulting firm that coupled the matrix to a
comprehensive methodology for developing strategic plans. It shows the cash flows and investment requirements at various
combinations of competitive strength and market life cycle stages.
While the market life cycle-competitive strength framework obviously provides a richer description than the growth-share
matrix its central message is the same. To see the relationship between these two frameworks, redraw the market life cyclecompetitive strength matrix with the growth-share matrix superimposed. This will reveal the similarities of the strategies suggested
by the corresponding positions on the two grids. Cash cows will still be in the upper right-hand quadrant, dogs in the
lower right-hand quadrant, and so on. The reason for this similarity becomes clear if you remember that market growth is closely
linked to the market life cycle and that market share is at once both a cause and an effect of competitive strength.
The Industry Attractiveness-Business Position Matrix
While the market life cycle-competitive strength matrix is more refined than the growth-share matrix, some have found
that its coverage of important issues remains limited. An alternative, the broadest portfolio management framework we will consider, is the industry attractiveness-business position matrix. This approach considers matters raised in the other two frameworks
and incorporates a range of other considerations, such as those shown in Exhibit 7.7.
Analysts typically combine information about such factors to reach a subjective evaluation of overall industry
attractiveness and business position. The strategic implications suggested by combining the resulting evaluation in a matrix are
identified in Exhibit 7.8.
Clearly, while this framework entails a very broad set of considerations, it is fundamentally similar to the simpler
frameworks described above. All these frameworks share three characteristics: (1) they consider some dimensions of both the
external environment and internal capabilities of a business; (2) they simplify information about environmental conditions and
business strengths by locating business units graphically on a two-dimensional matrix or grid; and (3) a business unit's position in
the matrix is treated as indicative of its likely need for, or ability to provide, financial resources (cash). Given these commonalities,
we can evaluate the usefulness of these portfolio management techniques as a group.
Benefits and Limits of Portfolio Management
Portfolio matrices offer useful frameworks for managers to consider potential differences among businesses in the same
corporation, and experience shows that they offer several potential benefits:58 (1) they summarize large amounts of general
information about individual business units and overall corporate plans; (2) they focus important differences among businesses and
help illustrate the rationale behind corporate plans to invest funds in business A that have been obtained from business B; (3) they
provide simple but useful guidelines for checking consistency between a business's requests for resources and opportunities for
using these resources effectively; and (4) they suggest reasonable performance levels for business units facing the various
strategic situations (obviously, the growth and profitability expected of a "star" are quite different from those expected of a "dog").
While these benefits are important, portfolio management should not be considered the sole, or even the primary, basis for
formulating corporate-level plans. It is more appropriately used as a tool that can help initiate a complete corporate strategy.59 One
commonly cited problem is that the simple matrices tend to trivialize thinking. To be fair, this criticism should probably be laid at
the feet of those who have misused them; they were never intended to replace careful thought, although in practice they sometimes
have done so.
Another problem with portfolio management is that individual businesses can be indistinguishable from one another. 60 No
exact principles dictate what constitutes a separate market or an individual product line. For example, should a beverage company
treat its coffee and tea operations as two businesses or one? Often yearly planning cycles don't allow enough time for detailed
analysis of every SBU in many large diversified firms. Therefore, even the most ardent supporters of portfolio approaches to
corporate management "fudge" a little on what constitutes an SBU in their portfolio planning. Firms usually recognize no more
than about thirty entities in their portfolios, regardless of how many businesses must be combined to reach this manageable
number.61
Finally, simple models of portfolio management are generally not very accurate. After 2 decades of use, it is now obvious
that models such as the BCG matrix have often led to inappropriate strategic moves because of their inaccuracy. For instance, one
study reported that more than half of all businesses that should have been cash users according to the BCG matrix were, in fact,
cash providers.62 On the other hand, roughly one-fourth of all businesses expected to be cash providers were, in fact, cash users.
"While no similar studies have been carried out for the other portfolio frameworks described here, any framework that reduces a
strategic situation to two dimensions will not be highly accurate in its prescriptions.
Thus, portfolio management has become one of the most involved and elaborate approaches to developing corporate
strategy. Consequently, our discussion of balancing cash flows has been considerably more extensive than that devoted to the other
benefits of diversification. We are now ready to turn to the last two of the six most commonly cited benefits of diversification.
Maintaining Growth
Diversification also provides continued growth. Especially among larger firms, diversification undoubtedly offers one of the most
common sources of growth. Using diversification, BASF, the giant German chemical company, was able to maintain a level of
growth through the 1980s more typical of rapidly growing start-up businesses, even though it was a mature, multibillion-dollar
multinational corporation. In the last half of that decade, BASF grew at an average of 36 percent per year, roughly doubling in size
every 2 years, from a base that was already huge.63
Is growth always desirable? Considerable argument revolves around the idea that corporations should pursue only moderate levels
of growth to generate the best return on stockholder investments. Beyond that, profitability likely declines as the pursuit of high
growth levels drives the corporation into more marginal businesses and the cost of operating the increasingly large corporation
outstrips the growth in profits that additional businesses might provide. Exhibit 7.9 helps us visualize this relationship.
Reducing Risk
Corporate managers sometimes justify diversification on the basis of risk reduction. 64 To understand how diversification
relates to risk, first note that different businesses respond differently to particular economic cycles: the demand for luxury cruise
vacations typically declines during recessions as consumers look for less expensive recreation, while demand for bus travel
typically increases, as this is a relatively inexpensive mode of transportation. We call businesses such as these two countercyclical.
In order to reduce the risk associated with volatile earnings, a single corporation might decide to diversify its portfolio by holdingboth a cruise ship line and a bus line. If such countercyclical businesses exist within the same diversified corporation, a bad year
for one business can be offset by a better year for the other. In this way, the variability of the overall corporation's earnings would
decrease, and stockholder investments less risky.65 .
However, investors do not need corporate managers to achieve this risk-reducing effect. They can simply invest their
individual funds in the different businesses (cruise ship operators and bus operators in this example) to achieve the same riskreducing effect: a bad year for one of their investments will be offset by the improved performance of their other investment, and
the risk associated with their overall portfolio of investments will decrease. In fact, individual investors can usually achieve such
risk reduction through diversification at a lower cost than corporate managers can because they do not have to pay the takeover
premium a corporation normally has to pay. This being the case, diversification for risk reduction alone hardly meets the goal of
having corporate managers create value for an investor in some way that the investor cannot accomplish alone. As we shall see in
the next section, forces at play can limit any of the six possible benefits of diversification listed in Exhibit 7.3.
MANAGERIAL BEHAVIOR THAT LIMITS THE BENEFITS OF DIVERSIFICATION
Creating value for stockholders in ways that they cannot do on their own is complicated by the fact that corporate
managers do not always benefit from diversification in the same way stockholders do. 66 To appreciate this important point,
understand the relationship between corporate managers and the corporation's stockholders. Theoretically, corporate managers are
to act as the agents for the stockholders, whose interests they are hired to represent.67 However, an area of research known as
agency theory leads us to ask whether managers always act in stockholders' best interest.68
Agency theory suggests that managers will not always place stockholders' interests above their own. 69 In fact, stockholders
have been dubbed the "least important constituency" by researchers who have examined how corporate executives manage the
diversification process.70 In managing diversification, corporate managers face a dilemma as they attempt to balance their own
interests against those of stockholders. For instance, stockholders often enjoy high profits from the sale of their stock when the
firm is taken over. On the other hand, managers of firms that have been taken over often lose their jobs. Critics contend that
corporate managers sometimes protect their jobs by using various anti-takeover tactics, even though avoiding the takeover often
reduces the value of stockholders' investments. Such controversial takeover tactics are described in Application 7.4. 72
In the following sections, we consider how each of the potential benefits of diversification can decrease because of conflicts
between the interests of managers and those of stockhoiders.
Capitalizing on Core Competencies
Managers in newly acquired businesses often resent and oppose transferring skills from the core business. Managers good enough
at their work to make their business an attractive acquisition may wonder why the new corporate parent presumes to know better.
In the case of Philip Morris and the Miller Brewing acquisition, Philip Morris ended up replacing several key Miller executives
who resisted the transfer of marketing skills from Philip Morris, even though Philip Morris was undoubtedly one of the best
marketers in the world. Philip Morris eventually overcame this obstacle, but other corporations are less fortunate and face
continued resistance from their acquisitions.
r
Increasing Market Power
Any corporate attempt to improve a business unit's market power by enhancing its structural position entails some loss of
autonomy or control on the part of the business's managers. To return to our earlier example of a confectioner acquired by Procter
& Gamble, to the extent that the candy maker is treated as part of the P&G family, it no longer controls its own destiny. For
example, its sales force may no longer be necessary; in order to give the business unit the greatest possible market power, its sales
will probably be handled as part of a centralized sales department's responsibilities, with each salesperson handling candy sales
along with sales of a variety of other P&G products. This diminished role for managers in the candy business is likely to meet
considerable resistance, and they may try to maintain independence from the larger corporation even though doing so will limit the
favorable impact on market power the corporate parent offers.
Sharing Infrastructures
Managers may feel threatened when a corporation attempts to have businesses share resources. A corporation may decide to have
one set of managers or one set of facilities serve two businesses; in this case, the other managers or facilities will no longer be
needed and some managers will lose their jobs. Clearly, managers have good reason to resist such efforts at making the corporation
more efficient.
Balancing Financial Resources
While balancing cash flows across businesses sounds logical, consider how managers might respond to having their businesses
labeled "dogs." How often are careers advanced by killing off a business efficiently, even if it is done for the good of the corporation? Individual managers often believe that their success depends more on the performance of their particular businesses rather
than on the performance of the corporation. In such circumstances, managers find it difficult to sacrifice their businesses for the
good of others in the portfolio, even if the corporation as a whole would benefit.
Maintaining Growth
Corporate growth seems to have at least as much to do with improving the welfare of managers as the welfare of
stockholders. Managers may be in favor of growth because they expect personal benefits from increasing the size of the
corporation. For example, managers in larger corporations typically get paid more than their counterparts in smallercorporations. 73
One study found that, other things being equal, for every 10 percent increase in company size, U.S. CEOs could expect a 2 percent
increase in annual pay74 This holds true even though larger corporations are not necessarily more profitable.
Larger corporations offer managers more prestige and more perquisites, or ~perks;" Every year the popular business press
celebrates corporate size with listings such as the Fortune 500, the 500 largest corporations in the United States. Business
professionals consider being :1 top-ranking executive at a large corporation more prestigious than holding a similar rank in a
smaller firm. Corporate jets, executive townhouses, lavish corporate headquarters, and so on, are all expensive perks. Larger corporations are more able to afford such perks, because they represent a smaller percentage of overall corporate assets and expenses.
Managers may also believe that larger corporations offer greater job security. Larger corporations were traditionally more
difficult to acquire by takeover, so, by increasing the size of their corporations, managers may think they are reducing the threat of
being replaced. With the ever-increasing size of takeover targets, this tactic may no longer work, but for most managers, it remains
a major consideration for acquisition.
Both corporations and stockholders can benefit from growth. However, the relationship between corporate size and
corporate financial performance is tenuous, and the benefits to growth appear to accrue more directly to managers than to the
stockholders they are presumably hired to serve.75 This suggests that growth alone is not a strong argument for diversifying. It is
probably more appropriate to consider growth as a by-product of diversification rather than as a reason for diversifying.
Reducing Risk
As we have seen, individual investors can diversify their stock portfolios using countercyclical stocks to reduce their
overall risks, so corporate diversification for the sake of risk reduction does not meet our standards for good strategy. However,
some corporate managers may pursue this tactic because it effectively reduces their own risks.76 When a corporation is involved in
a variety of industries, its total earnings are less volatile, which means that the earnings for which corporate managers are
responsible are more assured.'
Clearly, managers do not benefit from diversification in the same way owners do, and this difference often limits the
benefits owners derive from corporate diversification. In fact, if you return to Exhibit 7.3 and compare the things that benefit
stockholders and the things that benefit managers, you may reach the conclusion that the two have precisely opposite railings for
the six reasons we have discussed. While stockholders have much to gain from capitalizing on core competencies, improving
market power, and sharing infrastructure, managers have much to lose from the same. On the other hand, managers may benefit
from maintaining growth and reducing risk, although, as we have seen, there is little opportunity for stockholders to benefit from
corporations diversifying for these reasons alone. Balancing cash flows appears to offer mixed results for both parties.
All this suggests that one of the greatest challenges to corporate strategy is overcoming the differences in the motives of
owners and managers. One common way of doing this is to tie manager compensation to stock performance. This can be accomplished by granting stock options (options to buy stock at pre-specified prices) to managers or by selling stock to all employees on
favorable terms. Either option is meant to increase managers' and employees' interest in creating greater value for stockholders, the
goal of corporate strategy. .
.
Summary of Managerial Practices to Adopt from This Chapter
Remember that the key responsibility for managers at the corporate level is to see that stockholders' funds are invested in such a
way that they generate more value for the stockholders than stockholders could generate for themselves.
Corporate managers can continue to invest in their present businesses, or they can invest in different businesses, an option that
entails some form of diversification.
Use the relatively simple three-by-three matrix of "forms by means" to help you son out options for diversification. The most
common forms of diversification are vertical integration, horizontal diversification, and global diversification. Diversification is
usually carried out through acquisitions, strategic alliances, or internal development.
A corporation's level of diversification can also be influenced through divestments as its sells off businesses. Divestments are often
poorly managed, but remember that, if they are approached correctly, they too offer opportunities to create value for stockholders
in ways that stockholders cannot replicate for themselves.
As a manager, you should be aware that the benefits you personally receive from diversification are often different from, and
sometimes in conflict with, those realized by stockholders. You should consider the needs of both parties carefully in order to reach
an appropriately balanced approach to managing at the corporate level.
Perhaps the best justification for diversification is to be able to capitalize further on core competencies a corporation has already
developed, and your organization's core competencies should play an important role in shaping its diversification strategy. Other
good reasons for diversifying are opportunities to increase a business's market power, to utilize corporate infrastructures more
fully, and to facilitate shifting cash flows from businesses generating excess cash to those needing additional cash.
Other reasons frequently given for diversification are maintenance of growth and reduction of risk, but it is usually easier to see
how managers benefit from these than how stockholders do. .
Questions for Discussion and Review
1. Explain the meaning of this statement: "Firms should base decisions on diversification according to the criterion of generating
greater returns to stockholders than those stockholders would likely achieve if acting independently."
2. Describe the different forms of diversification and give an example of each.
3. Describe the different means of diversification and give an example of each.
4. Evaluate the most common reasons for diversifying in terms of their impact on competitive advantage and financial
performance.
5. Explain how managerial behavior can effectively limit stockholders' benefits from diversification.
Notes
1. Noel M. Tichy and Stratford Sherman, Control Your Destiny or Someone Else Will, New York: Doubleday, 1993.
2. Michael Goold and Kathleen Luchs, "Why Diversify? Four Decades of Management Thinking," Academy of Management Executives, 7:3
(1993), 7.
3. Michael Lubatkin, "Value-Creating Mergers: Fact or Folklore?," Academy of Management Executive, 2 (November 1988), 295-302.
4. You may recall that this is the basic idea behind the notion of economic value added described in Chapter 4; see also Shawn Tully, "The Real
Key to Creating Wealth,"
Fortune (September 20, 1993),38.
5. Alfred Rappaport, "Linking Competitive Strategy and Shareholder Value Analysis," Journal of Business Strategy (Spring 1987), 58-67; G. S.
Day and L. Fahey, "Putting Strategy into Shareholder Value Analysis," Harvard Business Review (March-April 1990), 156-162; Alfred
Rappaport, "CFOs and Strategists: Forging a Common Framework," Harvard Business Review (May-June 1992), 84-91.
6. Michael Porter, "From Competitive Advantage to Corporate Strategy," Harvard Business Review, 65 (May-June 1987), 43-59.
7. O. "Williamson, Markets and Hierarchies: Analysis and Antitrust Implications, New York: The Free Press, 1975.
8. This point is discussed in some detail in R. H. Hayes and W J. Abernathy, "Managing Our Way to Economic Decline," Harvard Business
Review (July-August 1980), 67.
9. These questions are adapted from Kathryn Harrigan's research presented in "Matching Vertical Integration Strategies to Competitive
Conditions," Strategic Management Journal, 7 (November-December 1986), 535-555; and John Stuckey and David White, "When and When Not
to Vertically Integrate," Mcf{jnsey Quarterly (Summer 1993), 3-27. These and additional criteria are discussed in D. B. Ewaldz, "How Integrated
Should Your Company Be?," Journal of Business Strategy (July-August 1991), 52-55.
10. James Brian Quinn, Thomas L. Doodey, and Penny C. Paquette, "Beyond Products: Services-Based Strategy," Harvard Business Review
(March-April 1990), 58-68.
11. For a ~omparison of ownership versus other forms of integration, see Joseph 1: Mahoney, "The Choice of Organizational Form: Vertical
Financial Ownership Versus Other Methods of Vertical Integration," Strategic ManagementJourna~ 13 (1992),559-584.
12. See discussion of how far to integrate along an industry's "surplus chain" in Alistair M. Hanna and Jerrold 1: Lundquist, "Creative Strategies,"
Mcf{jnsey Quarterly (Summer 1990),56-79.
13. J. B. Barney, "Returns to Bidding Firms in Mergers and Acquisitions: Reconsidering the Related Hypotheses," Strategic ManagementJournal,
9 (special issue, 1988), 71-78; V. Part Three Strategy Fonnulation Ramanujam and P. Varadarajan, "Research on Corporate Diversification: A
Synthesis," Strategic Management Journal, 10 (1989), 523-551.
14. Michael Lubatkin, "Merger Strategies and Stockholder Value," Strategic Management Journal, 8 (1987),39-53; S. Chatterjee, "Types of
Synergy and Economic Value: The Impact of Acquisitions on Merging and Rival Firms," Strategic Management Journal, 7 (1986),119-140.
15. M. Leontiades, "The Rewards of Diversifying into Unrelated Businesses," Journal of Business Strategy, 6 (Spring 1986), 81-87.
16. To learn the fascinating story of how such a corporation was built, read the entertaining How to Lose $1,000,000,000 and Other Valuable
Advice by Royal Little, Boston: Little, Brown, 1979.
17. For a discussion of the managerial practices that allow firms to better realize the advantages of broad diversification, see Roland Calori and
CESMA, "How Successful Companies Manage Diverse Businesses," Long Range Planning, 21:3 (1988), 80-89.
18. For example, research indicates that the best way to protect shareholder value against economic downturns is to diversify only to the extent
that "all of one's eggs are in similar baskets"; see M. Lubatkin and S. Chatterjee, "The Strategy-Shareholder Value Relationship: Testing
Temporal Stability Across Market Cycles," Strategic Management Journal, 12 (May 1991), 251-270.
19. M. S. Davis, "Two plus Two Doesn't Equal Five," Fortune (June 25, 1985), 177.
20. William M. Bulkeley, "Conglomerates Make a Comeback-with a '90s Twist," Ulall Street Journal (March 1, 1994), 1.
.:
21. Mergers refers to the act of combining tWo corporations, but this usually entails one corporation acquiring the other. Therefore, to simplify
this material, we do not make a distinction betWeen acquisitions and mergers. For a discussion of the shared strategic goals of mergers and
acquisitions, see G. A. Walter and]. B. Barney, "Management Objectives in Mergers and Acquisitions," Strategic Management Journal (January
1990), 79-86.
22. For research on how synergies and restrUcturing are sources of value creation through acquisition, see Sayan Chatterjee, "Sources of Value in
Takeovers: Synergy or RestrUcturing-Implications for Target and Bidder Firms," Strategic Management Journal, 13 (1992), 267-286.
23. D. Foust and T. Smart, "The Merger Parade Runs into a Brick Wall," Business Week (June
25,1990),38. 24. Anne B. Fisher, "How to Make a Merger Work," Fortune (January 24,1994),66-70. 25. For an in-depth treatment of what
managers can do pre- and postacquisition to improve their chances of success, see Philippe C. Haspeslagh and David B. Jemison, Managing
Acquisitions: Creating Value Through Corporate Renewal, New York: The Free Press, 1991.
26. See Walter R. Nord, "Do Mergers Make Acquired Exe~tives Feel Inferior? You Bet!," Academy of Management Executive, 8:2 (1994),81-82;
and James P. Walsh and John W. Ellwood, "Mergers, Acquisitions, and the Pruning of Managerial Deadwood," Strategic ManagementJournal,
12 (1991), 201-217.
27. Fisher, "How to Make a Merger Work."
28. Kathryn Harrigan, "Joint Ventures and Competitive Sttategy," Strategic Management Journal, 9 (March-April 1988), 141-158.
29. Stratford Sherman, "Are Strategic Alliances Working?," Fortune (September 21,1992),77-78. 30. C. E. Schillaci, "Designing SuccessfulJoint
Ventures," Journal of Business Strategy (Fall 1987),59-63; David Lei and John W Slocum, Jr., "Global Strategy, Competence Building and
Strategic Alliances," California Management Review (F all 1992 ), 81-97; Joseph L. Badaracco,Jr., "Alliances Speed Knowledge Transfer,"
Planning Review (March-April 1991), 10-16.
31. M. Niederkofler, "The Evolution of Strategic Alliances: OpportUnities for Managerial Influence," Journal of Business Venturing, 6 (1991),
237-257. 32. P. R Scanlon, "Collaborative Ventures," Journal of Business Strategy (July-August 1990), 81-83. 33. These and other important
considerations are discussed in K R. Harrigan, Managingfor Joint Venture Success, Lexington, MA: D. C. Heath, 1986.
34. P. Lorange and J. Roos, "Why Some Strategic Alliances Succeed and Others Fail," Journal of Business Strategy (January-February 1991), 2530.
35. For discussion of the determinants of success in corporate entrepreneurship, see S. A. . Zahra, "Predictors and Financial Outcomes of Corporate
Entrepreneurship: An Exploratory Study," Journal of Business Venturing, 6 (1991),259-285; A. Miller and B. Camp, "Exploring Determinants of
Success in Corporate Ventures," Journal of Business Venturing, 1 (1985),87-105; and R. A. Burgelman, "Managing New Venture Division:
Research Findings and Implications for Strategic Management," Strategic Management Journal, 6 (January-February 1985), 39-54.
36. This typology of new-venture programs was developed in a Harvard Business School research program on corporate entrepreneurship headed
by Rosabeth Moss Kanter; see Ian MacMillan, "Introduction of Kanter's Case Series," Journal of Business Venturing, 5 (1990),413.
37. H. Sykes, "Lessons from a New Ventures Program," Harvard Business Review (May-June 1986),69"'-74.
38. Other corporations have been far less successful in acting as venture capitalists. See R. M. Kanter et al., "Engines of Progress: Designing and
Running Entrepreneurial Vehicles in Established Companies," Journal of Business Venturing, 5 (1990),415-430.
39. An often overlooked resource which can be highly valuable to a new corporate venture is the corporation's image. See M L. Williams, M.
Tsai, and D. Day; "Intangible Assets, Entry Strategies, and Venture Success in Industrial Markets," Journal of Business Venturing, 6 (1991),315333.
40. Alex Miller, Mary Spann, and Linda Lerner, "Competitive Advantages in New Corporate Ventures: The Impact of Resource Sharing and
Reporting Level," Journal of Business Venturing, 6 (1991),335-350.
41. R. M. Kanter et aI., "Engines of Progress: Designing and Running Entrepreneurial Vehicles in Established Companies; The New Venture
Process at Eastman Kodak, 1983-1989," Journal of Business Venturing, 6 (1991), 63-82.
42. R. M. Kanter et aI., "Engines of Progress: Designing and Running Entrepreneurial Vehicles in Established Companies; Raytheon's New
Product Center, 1969-1989," Journal of Business Venturing, 6 (1991), 145-163.
43. Giffor~ Pinchot, Intrapreneuring, New York: Harper & Row, 1985.
44. M. Cosgrove, "Roadblocks to New Business Development," Journal of Business Strategy (May-June 1991),53-57.
45. Statistical analysis indicates that 45 percent of the variability in new-venture performance in Exxon Enterprises can be explained by just two
factors: market risk and technological risk; Sykes, "Lessons from a New Ventures Program."
46. H. R. Biggadike, "The Risky Business of Diversification," Harvard Business Review, 57 (May-June 1979), 103-111.
47. R. M. Kanter and L. Richardson, "Engines of Progress: Designing and Running Entrepreneurial Vehicles in Established Companies; The
Enter-Prize Program at Ohio Bell, 1985-1990," Journal of Business Venturing, 6 (1991),209-229.
48. Porter, "From Competitive Advantage to Corporate Strategy."
49. See discussion in H. Harowitz and D. Halliday, "The New Alchemy: Divestment for Profit," Journal of Business Strategy, 5 (Fall 1984), 112116.
50. E. L. Hennessy, Jr., "The Ethics of Corporate Restructuring," Directors &- Boards, 13 (Fall 1988),8-12.
51. C. K. Prahalad and G. Hamel, "The Core Competence of the Corporation," Harvard Business Review (May-June 1990), 79-91; Amy v:
Snyder and H. William Ebeling, Jr., "Targeting a Company's Real Core Competencies," Journal of Business Strategy, 13 (November-December
1992), 26-32.
52. Prahalad and Hamel, "The Core Competence of the Corporation"; Porter, "From Competitive Advantage to Corporate Strategy."
53. P. Sloan, "Brand Names Seek New Wrinkle with Clothes," Advertising Age (April 28, 1986),28.
54. R. Reed and R. J. DeFiIIippi, "Causal Ambiguity, Barriers to Imitation, and Sustainable Competitive Advantage," Academy of Management
Review, 15 (1990),88-102. 55. Porter, "From Competitive Advantage to Corporate Strategy." 56. B. Hedley, "Strategy and the Business
Portfolio," Long Range Planning, 10 (February 1977),9-15.
57. For a thorough comparison of these various portfolio management techniques, see D. F. Abell and]. S. Hammond, Strategic Market
Planning, Eng~wood Cliffs, NJ: Prentice Hall, 1979.
58. P. Haspeslagh, "Portfolio Planning: Uses and Limits," Harvard Business Review, 60 (January-February 1983), 58-73.
.
59. A. C. Hax and N. S. Majluf, The Strategic Concept and Process, Englewood Cliffs, NJ: Prentice-Hall, 1991.
60. For an in-depth discussion of the problems of identifying individual businesses within larger diversified corporations, see D. F. Abell,
Defining the Business: The Starting Point of Strategic Planning, Englewood Cliffs, NJ: Prentice-Hall, 1980.
61. R. A. Proctor, "Strategic Planning: An Overview of Product Portfolio Models," Marketing Intelligence and Planning, 8:7 (1990), 4-10.
62. R. D. Buzzell and B. T. Gale, The PIMS Principles: Linking Strategy to Performance, New York: The Free Press, 1987.
63. "Capital Cargo-More German Marks for U.S. Chemical Operations," Chemical week (June 25,1985),24-27.
64. There are several forms of corporate risk. The risk to which we refer here is technically called business risk. Consideration of other types of
risk is not feasible here. Those who need further information on this should see K. D.Miller, "Strategic Risk and Corporate Performance: An
Analysis of Alternative Risk Measures," Academy of Management Journal, 33 (1990),756-779.
65. Some research suggests that reducing variability in this way improves cash flow and allows corporations to acquire factors of production (e.g.,
capital equipment) at lower costs, but this is too advanced for coverage here. Those interested are referred to R. Amit and B. Wernerfelt, "Why
Do Firms Reduce Business Risk?," Academy of Management Journal, 33 (1990), 520-533.
66. B. M. Oviatt, "Ag~ncy and Transaction Cost Perspectives on the Manager-Shareholder Relationship: Incentives for Congruent Interests,"
Acodemy of Management Review (April 1988),214-225; Lubatkin, "Value-Creating Mergers."
67. We are using "agent" here in the legal sense of one authorized to transact business, including executing contracts, for another; S. Davidson, C.
Stickney, and R. Weil, The Language of Business, New York: Prentice-Hall, 1984.
68. K.M. Eisenhardt, "Agency Theory: An Assessment and Review," Academy of Management Review, 14 (1989),57-74.
69. M. C. Jensen and w: H. Meckling, "Theory of the Firm: Managerial Behavior, Agency Costs, and Ownership Structure," Journal of Financial
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70. P. C. Haspeslagh and D. B.Jemison, "Acquisitions: Myths and Reality," Sloan Management Review, 28 (Winter 1987), 53-58.
71. R. w: McGee, "Ethical Issues in Acquisitions and Mergers," Mid-Atlantic Journal of Business (March 1989), 19-39; P. H. Werhane, "Two
Ethical Issues in Mergers and Acquisitions," Journal of Business Ethics, 7 (January-February 1988), 41-45.
72. Empirical evidence of how antitakeover measures are used for the benefit of managers rather than owners is presented inJames M. Mahoney
and Joseph T. Mahoney, "An Empirical~Investigation of the Effect of Corporate Charter Antitakeover Amendments on
Stockhglder Wealth," Strategic Management Journal, 14 (1993), 17-31.
.
73. R. A. Lambert, D~ F. Larcker, and K. Weigelt, "How Sensitive Is Executive Compensation to Organizational Size?," Strategic
ManagementJournal, 12 (July 1991), 395-402. 74. G. S. Crysta~ "Seeking the Sense in CEO Pay," Fortune, 119 (June 5, 1989),88-104.
75. For further discussion of how corporations and managers benefit from growth through diversification, see D. R. Dalton and I. F. Kesner,
"Organizational Growth: Big Is Beautiful," Journal of Business Strategy, 6 (Summer 1985), 38-48.
76. Walter and Barney, "Management Objectives in Mergers and Acquisitions."